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29 March 2013

Why China can maintain 8% growth

China’s National People’s Congress (NPC) has set a 7.5% official GDP growth target for this year. Lin Yifu, former Senior Vice-President and Chief Economist of the World Bank, and one of China’s most important economists, predicts that China can maintain 8% annual growth for 20 years. A key question is evidently whether such targets are realistic. Can China maintain this type of growth rate?

The immediate negative factors are evident. The international context for China’s economy this year is bad. The Eurozone economy is shrinking, Japan is stagnant and US growth is anemic. A 16% fall in world commodity prices since their peak has led to slower growth in major developing economies such as Brazil.

China’s policy makers initially underestimated the problems in the advanced economies. Adjusted for inflation, imports by developed economies have not regained pre-financial crisis levels. China therefore did not achieve its 2012 target of a 10% trade increase – the ctual rise was 6.2%. The lower 8% trade growth target set for 2013 is more realistic if still challenging. All major motors for growth will therefore have to come from China’s domestic economy.

In terms of strengthening China’s relative international economic position, and maintaining its ranking as the world’s most rapidly growing market, all this makes no difference. China is the world’s most open major economy, so it cannot cut itself off from international trends. China’s growth rate inevitably goes up or down with global economic fluctuations – the constant is that China strongly outperforms these trends.

To give more precise numbers, a rule of thumb of over 20 years, which successfully passed the test of events, is that China grows on average at whatever the advanced economies expand at plus 6% - the greater outperformance during the financial crisis was untypical. Developed economies this year will probably grow at around 1.5-2.0%, implying China will grow at 7.5-8.0% - in line with official forecasts. This is consistent with the official target of doubling the size of China’s economy between 2010 and 2020.

But for estimating expansion of China’s market, and growth of living standards, the absolute rate at which China’s economy develops is obviously key. It is therefore worth looking beyond short term ups and downs to the fundamental factors determining how fast an economy grows. This makes clear why China will achieve its 7.5-8% growth target. It also eliminates ‘manic-depressive’ analyses of China’s economy – periodic oscillating predictions of ‘hard landing’ and ‘rampant growth’ which appear in some parts of the media.

The current infatuation with examining consumption in China’s GDP is misleading in terms of analysing its economic performance. A country’s consumption growth is overwhelmingly determined by its GDP growth – internationally 87% of consumption increase is determined by the latter. If China’s GDP grows rapidly consumption will grow rapidly. If China’s GDP growth slows its consumption, over anything other than the very short term, will be lower than its potential with high GDP growth.

Every economy’s growth, including China’s, is necessarily determined by two key parameters: how much it invests and how efficiently that investment creates growth. Taking the five year average for 2006-2011, the latest internationally comparable data, China’s fixed investment was 43.1% of GDP, and it invested 4.1% of GDP for its economy to grow by a percentage point. Consequently, as a matter of simple arithmetic, China’s economy grew at an annual average 10.5%.

The lower the percentage of GDP invested for any given economic growth the more efficient that investment is. Furthermore, contrary to some myths, China’s investment is extremely efficient by international standards as the Table shows. For example in 2006-2011 China needed to invest 4.1% of GDP to grow by 1% whereas the US invested 24.3% - China’s investment was six times as efficient in generating GDP growth as the US. Even before the international financial crisis the US invested 7.0% of GDP to grow by 1% compared to China’s 3.4%. These key numbers determine how fast China’s economy grows.

Table 1

If China’s economy is to slow, as some critics argue, then it is necessary one or both of these key parameters changes. Either China’s percentage of investment in GDP must fall or the efficiency of its investment in generating GDP growth must decline – there are no other choices.

Taking first investment efficiency, the Table shows that almost all economies were negatively affected by the international financial crisis. China was no exception – the percentage of GDP which had to be invested for its economy to grow by a percentage point rising from 3.4% to 4.1%. But this deterioration was less than for most countries – the US figure rose from 7.0% to 24.3%, Germany’s from 8.2% to 18.4%.

China’s investment efficiency would have to fall greatly not to achieve its 7.5% growth target. If China’s recent investment level was maintained then the percentage of GDP it needs to invest to grow by a percentage point would have to rise to over 5.7% before China failed to hit its growth rate target. Maintaining China’s efficiency of investment is therefore a constant challenge for the government, but China has a considerable safety margin in setting its target growth. The government’s entire focus is on maintaining the efficiency of investment, not reducing it.

The other possibility for slowing China’s economy would be a sharp reduction in the percentage of investment in GDP. There are certainly some in China advocating reducing the level of investment in GDP, but not by nearly enough to prevent China hitting its growth targets. At its present level of investment efficiency China’s GDP growth rate falls by 1% for each 4.1% reduction in the percentage of fixed investment in GDP. But in the last 5 years China’s annual GDP growth averaged 10.5%. To reduce China’s GDP growth below 7.5% requires a fall in the percentage of investment of GDP of 10%. No serious figure in China, as opposed to a few Western analysts, advocates this. A fall in investment share of 2-4% of GDP, the type of figure sometimes advocated, would only slow China’s economic growth by 0.5-1.0%.

Therefore international economic headwinds are negative. But in both the efficiency of its investment and the percentage of investment in GDP China has considerable safety margins for achieving its growth targets - unless the administration makes very large errors the growth targets will therefore be met. Indeed, looking at these margins of manoeuvre, Lin Yifu’s 8% is perhaps more realistic that the government’s 7.5% - administrations always like to announce they have exceeded targets.

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This article is slightly edited for an international audience from one which originally appeared in Shanghai Daily.

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John
Any comments on Martin Wolf's more pessimistic view

Martin Wolf of the Financial Times has even gone so far as to pen an article titled, ‘Why China’s economy might topple’. Wolf generally speaks on behalf of conventional and institutional thinking. A contrarian would be tempted to view his bearish comments on China quite bullishly. But his main point is that after 35 years of double-digit GDP growth, China will grow more like the advanced economies of Japan in the 1970s and South Korea in the 1990s, at about 6.5% a year.

Officials at China’s Development Research Centre of the State Council (DRC) have written a paper called ‘Ten-year outlook: Decline of Potential Growth Rate and Start of New Phase of Growth’. The clunkily titled paper lays out five reasons why China may experience a sharp decline in growth, starting now. Wolf writes:

‘First, the potential for infrastructure investment has ‘contracted conspicuously’, with its share in fixed asset investment down from 30 per cent to 20 per cent over the past decade. Second, returns on assets have fallen and overcapacity has soared. The ‘incremental capital output ratio’ – a measure of the growth generated by a given level of investment – reached 4.6 in 2011, the highest since 1992. China is getting less growth bang for its investment buck. Third, growth of the labour supply has fallen sharply. Fourth, urbanisation is still rising, but at a decelerating rate. Finally, risks are growing in the finance of local governments and real estate.’

Greg Canavan looked into most of those factors last year in his ‘China Bust’ report. The recovery of iron ore prices after their big dip last August caused a lot of people to brush off Australia’s China worries. But between Wolf’s five points and Stockman’s point about the end of the infrastructure boom, it is impossible to ignore the fact that China can’t keep spending money it doesn’t have on infrastructure and development projects that generate no real return on capital.